Master Limited Partnership - MLP

What is a 'Master Limited Partnership - MLP'

A master limited partnership (MLP) is a type of business venture that exists in the form of a publicly tradedlimited partnership. As such, it combines the tax benefits of a partnership – profits are taxed only when investors actually receive distributions – with the liquidity of a public company.

MLPs have two classes of partners:

Limited partners: investors who purchase shares in the MLP and provide the capital for the entity's operations. They receive periodic distributions from the MLP, typically on a quarterly basis.

General partners: owners who are responsible for managing the day-to-day operations of the MLP. They receive compensation based on the partnership's business performance.

BREAKING DOWN 'Master Limited Partnership - MLP'

An MLP is a partnership that is traded on a national exchange, which offers significant tax advantages to both the general and limited partners. MLPs are situated to take advantage of cash flow, as they are required to distribute all available cash to investors. MLPs can help reduce the cost of capital in capital-intensive businesses, such as the energy sector.

And in fact, by law most MLPs currently operate in the energy industry, providing and managing resources: One example is Texas-based Genesis Energy L.P., which provides pipeline transportation, refinery services, and supply and logistics support services for oil companies.

Many oil and gas companies issue MLPs instead of corporate stock. With this structure, corporations or individuals can own a stake. A company is likely to own interest in its own MLP. Subsequently, separate stock-issuing corporations are also set up, with the sole business being to own shares (officially, units) of the company MLP, redistributing the passive income through the corporation as a regular dividend.

A good example of this structure is Linn Energy Inc., which has both an MLP (LINE) and a corporation that owns an interest in the MLP (LNCO). Investors then have the option to choose, for tax purposes, how they would like to receive the income the company generates.

History of Master Limited Partnerships

The first MLP was organized in 1981. In 1987, Congress effectively limited the use of MLPs to real estate and energy companies. These limitations were put into place as a result of the perceived loss of corporate tax, since MLPs do not pay federal taxes. To qualify for the pass-through status, at least 90% of the MLP's income must be qualifying income, which is generally defined as income realized from the exploration, production or transportation of natural resources or real estate. In other words, to qualify as an master limited partnership, a company must have all but 10% of its revenues be from commodities, natural resources or real estate activities. This definition of "qualifying income" reduces the sectors in which MLPs can operate.

Characteristics of an MLP

The MLP is a unique hybrid legal structure that combines elements of a partnership with elements of a corporation. First of all, it is considered the aggregate of its partners rather than a separate legal entity (as a corporation would be). Second, it technically has no employees; the general partners are responsible for providing all necessary operational services. General partners usually hold a 2% stake in the venture and have the option to increase their ownership.

Like a partnership, an MLP issues units instead of shares. However, these units are often traded on national stock exchanges, offering significant liquidity – a liquidity that traditional partnerships do not offer. Because these publicly traded units are not shares of stock, those who invest in MLPs are commonly referred to as unitholders, rather than shareholders. Those who buy into an MLP are also called limited partners; they are allocated a share of the MLP's income, deductions, losses and credits.

Tax Advantages of MLPs

An MLP is treated as a limited partnership for tax purposes. A limited partnership has a pass-through, or flow-through, tax structure, meaning that all profits and losses are passed through to the limited partners. In other words, the MLP itself is not liable for corporatetaxes on its revenues, as most incorporated businesses are; instead, its owners/unitholders/investors are only personally liable for income taxes on their portions of the MLP's earnings. This offers a significant tax advantage; profits are not subject to the double taxation scenario in which corporations pay corporate income taxes, and then shareholders must also pay personal taxes on the income from their stocks. Further, deductions such as depreciation and depletion are also passed on to the limited partners. Limited partners can use these deductions to reduce their taxable income.

Quarterly distributions from the MLP are not unlike quarterly stock dividends. But they are treated as a return of capital, as opposed to income, and so the unitholder doesn't pay income tax on them. Most of the earnings are tax-deferred until the units are actually sold; and then, they're taxed at the lower capital gains rate rather than at the higher personal income rate. This offers significant additional tax benefits.

More MLP Advantages

MLPs are known for offering slow investment opportunities, which stems from the fact that they’re often in slow-growing industries, like pipeline construction. This means low risk. Because they earn a stable income that is often based on long-term service contracts, MLPs are conducive to offering steady cash flows, which lead to consistent cash distributions. Those cash distributions usually grow slightly faster than inflation, and for limited partners, 80%-90% of them are often tax-deferred. Overall, this enables MLPs to offer attractive income yields (commonly substantially higher than the average dividend yield of equities). And the flow-through entity status, by avoiding double taxation, leads to more capital being available for future projects, which then makes the MLP firm more competitive in its industry.

For the limited partner, cumulative cash distributions usually exceed the capital gains taxes required to be paid once all units are sold.

There are benefits for using MLPs for estate planning, too. If a unitholder gifts or transfers the MLP unit to beneficiaries, both will avoid paying taxes during the time of transfer; the cost basis will be readjusted based on the market price during the time of the transfer. If the unitholder dies and the units pass to heirs, their fair market value is determined to be the value as of the date of death, and the prior distributions are not taxed.

MLP Downsides

Perhaps the biggest disadvantage to being a limited partner in an MLP is that you will have to file the infamous Schedule K-1 form. This is a much more complicated animal than a 1099-DIV, which means you will have to pay your accountant more on an annual basis, even if you didn’t sell any units (for cash distributions). And K-1 forms are notorious for arriving late, to the despair of many tax preparers. An added problem: Some MLPs operate in more than one state, which means you might have to file in several states, which will increase your costs.

Another tax-related negative is that you can’t use a net loss to offset other income. Any net losses must be carried forward to the following year. When you eventually sell all your units, a net loss can then be used as a deduction against other income.

A final negative is limited upside potential (historically), but this is to be expected from an investment that’s going to produce a gradual but reliable income stream.